ETFs Carry The Day Over Stock Selection For Income, For Now

Includes: AGG, CVY, HYG, LQD, VIG, VYM
by: Dale Roberts

In a recent series of articles I explored the use of ETFs to create portfolios that would provide income and a level of price protection. This is a combination that would be useful in the drawdown phase for investors, especially if they are harvesting the income and at times selling assets to fund their retirement. More investors certainly do liquidate assets in the drawdown phase, so price protection along with generous income can go a long way to protect your nest egg.

That said, a very basic portfolio will do the trick in "the good times" that is, when markets are rising. Every week I see clients who have been drawing down against their very simple but effective index-based balanced portfolios that we offer - who have not had the portfolio value affected by the drawdown over the last 5 years. Their balance is essentially the same today as it was 3, 4, or 5 years ago. Not only that, the minimum drawdown rate in Canada (for retirees) is much higher than in the U.S. The minimum required drawdown rate in Canada begins at 7.48% at age 71 while in the U.S. the rate is 4%.

Everything's pretty easy in the good times, and it's certainly in the more volatile times when price protection will come in handy. Another defense against portfolio volatility of course is to create a reliable income stream that meets your spending needs in retirement. If you only need the minimum 4% drawdown and your portfolio is delivering 4% or over you're in very good shape to say the least. If your income is growing above the rate of inflation then you're also protecting your portfolio against a retiree's arch enemy - inflation. There are a few ways to beat inflation. One, simply hold assets that pay you a rate that compensates for the annual increase in the cost of living. If you are drawing down 4% and your portfolio is delivering 5% income you have a nice spread - some extra 1% income. An investor may choose to move those proceeds not needed for immediate spending to a cash account and build up a "buffer fund" of cash. Or they may choose to roll the dice and reinvest that additional income back into their mix of stocks and bonds.

Another popular investing style is to hold companies that have a long history of increasing their dividends. Of course, that style goes by the name of dividend growth. Many investors will hand select their dividend growth companies with the help of the master list of dividend growth companies managed by fund manager and SA author David Fish. You can find that site here.

There are literally hundreds of U.S. companies that have an extended history of increasing their dividends year after year, and at a rate well above inflation.

Many investors are having great success managing their own portfolios, creating a reliable and increasing revenue stream. SA writer and prolific "commenter" Chowder manages a public portfolio that he started in 2011. And book author and SA writer David Van Knapp offers a public portfolio that he began in June of 2008. You can find David's portfolio here. And as you can see, he has done an amazing job of creating a growing income stream in the accumulation phase.

David's launch date of June of 2008 is both fortunate and challenging. It was already apparent that the banking crisis was severe, and that financials were very risky investments. In March 2008, the Federal Reserve Bank of New York provided an emergency loan to try to avert a sudden collapse of the company. However, the company could not be saved and was sold to JP Morgan Chase (NYSE:JPM) for $10 per share. Much more bad news was to follow in quick order.

Leading up to the financial crisis, U.S. banks had been dividend stalwarts and would have been staples in many dividend based portfolios. Here's a look at Wells Fargo's (NYSE:WFC) long-term dividend history according to

(Click to enlarge)

That looks pretty enticing to me. To each his own, but if I was a dividend or dividend growth investor through the 90s and early 2000s I think WFC might have been in my portfolio. What's also interesting is that WFC made it through the tech-inspired stock market correction of 2000 without any damage. In fact, they increased their dividend through that crisis. Not a surprise in retrospect, 2000 was a tech meltdown, 2008 and beyond was or is a financial crisis. Did we fix that crisis, or are we still in that crisis, or creating a new type of debt fueled financial crisis? Only time will tell.

And here's Bank of America's (NYSE:BAC)dividend history.

(Click to enlarge)

Mr. Van Knapp had lots of warning signs already flashing before June of 2008, but certainly he deserves a lot of credit for not stepping on the financial landmines. That helped him in the short term to say the least. That said, as the above Wells Fargo chart shows, perhaps a very patient investor with a very long time horizon would still be rewarded with growing income in the accumulation stage. Over a 15 or 20 year time horizon, 2008 to 2009 might look like a blip.

All said, David had to navigate through troubled waters and he did so with great patience and judgment. In June of 2008 the stock markets had just begun their correction. The markets had fallen by over 12%, but the real fall was to come. Markets of course corrected by almost 60% from top to bottom from 2008 through 2009.

Back in the mid 2000's I thought BAC looked pretty good, a nice risk return proposition. I held BAC, bought more to average down and then sold all at a steep loss as I was concerned that it would go to zero. Only government intervention would save that prospect. Many others were in the same boat as you can read from the comment section in my article Losing It Big Time with Bank of America. They were tough times and financials were staples in many portfolios of all stripes. Over 30% of dividend champions cut, reduced or eliminated their dividends through the crisis.

I guess that's why I am no longer a stock picker. Ha. Which bring us to ETFs and indexing. I prefer to let the ETFs make the mistakes for me, if there are any to be made. ETFs provide diversification and passive management for the most part. And it can be more passive an investment on the holder side of the equation. A holder of an ETF does not have to rely on their own judgment. It is easier to be more emotionally detached. But can passive ETFs compare to an individual stock picker's skills and judgment?

In this article, I created a diversified stock and bond portfolio by combining two popular dividend ETFs from Vanguard (NYSEARCA:VYM) and (NYSEARCA:VIG) with the broad based bond ETF (NYSEARCA:AGG) and the corporate bond ETF (NYSEARCA:LQD). Here's what that income stream looked like in the accumulation phase with equal reinvestment of income back into the dividend stocks and bonds. For this test I assigned $10,000 to each ETF.

Start Date of January 2007.

ETF Dividends Bonds Total Growth
TOT 07 422 1033 1455
TOT 08 480 1076 1556 7%
TOT 09 428 1074 1502 -3%
TOT 10 441 1055 1496 0%
TOT 11 527 1051 1578 5%
TOT 12 641 1031 1672 6%
TOT 13 685 886 1571 -6%

The problem is obvious, with falling rates and yields we have falling income on the bond side. After the challenges of 09 and 10, the dividends are growing at a very reasonable pace. To try and fix that income dilemma, I then rerouted all of the income from the bonds and dividends back into the growing dividend stream.

This is what that experiment produced. The dividends below are now growing at a rate CAGR of 22%. The bond income was left alone, to fall while still delivering some generous yield for dividend reinvestment.

Start Date of January of 2007

ETF Dividends Bonds Total
TOT 07 435 991 1426
TOT 08 501 969 1470
TOT 09 470 927 1290
TOT 10 511 883 1394
TOT 11 630 853 1483
TOT 12 794 743 1538
TOT 13 932 656 1588

I then went a step further in this exploration. A multi asset class income investor will utilize more diversification and some higher yield products. I then simply used the multi asset class ETF from Guggenheim (NYSEARCA:CVY) and combined it with the high yield ETF (NYSEARCA:HYG), and then fed that higher yield back into the dividend stream of VYM. You can find The Ultimate Income Portfolio here.

Here's what that experiment produced.

Total CVY / HYG Income Reinvested to VYM.

Start Date of January of 2007

ETF Dividends CVY Total
TOT 07 566 1152 1718
TOT 08 687 1216 1903
TOT 09 591 1078 1669
TOT 10 595 960 1555
TOT 11 783 1000 1783
TOT 12 956 1248 2204
TOT 13 1170 1066 2236

How does multi income stack up against the public portfolio of DVK?

Here's the income stream of VYM from David's start date. I started with a portfolio value equal to that of David's portfolio ($46,780) with 50% of the total purchasing units of VYM, 35% purchasing units of CVY and 15% purchasing units of HYG. With the Cranky Maneuver, all income from the portfolio was reinvested back into VYM.

06 .37
Dist 202
09 .37
Dist 210
12 .33
Dist 194
2008 606
03/09 .31
Dist 187
06 .26
Dist 161
09 .26
Dist 165
12 .32
Dist 208
2009 721
03/10 .23
Dist 152
06 .27
Dist 182
09 .28
Dist 192
12 .31
Dist 217
2010 743
03/11 .31
Dist 221
06 .34
Dist 246
09 .31
Dist 228
12 .38
Dist 285
2011 980
03/12 .33
Dist 252
06 .37
Dist 287
09 .40
Dist 315
12 .49
Dist 392
2012 1249
03/13 .36
Dist 293
06 .42
Dist 347
09 .44
Dist 369
12 .49
Dist 416
2013 1425

We can see the dividends being fueled by some high test income are growing at a great pace, even doubling from 2009 to 2013.

And here is the total income stream from the portfolio with yield on cost.

Start Date of June 1 of 2008.

2008 606 1064 1670 3.5%
2009 721 1270 1991 4.2%
2010 743 1244 1987 4.2%
2011 980 1294 2247 4.8%
2012 1249 1295 2544 5.4%
2013 1425 1377 2802 6%

The dividend growth rate from the start date is 18.65%. Over the last 3 years that rate has accelerated to 24.2%, from 2010. The total income growth rate for the portfolio is 8.9% from 2009 base.

And here's the total income comparison of the ETF portfolio vs. David Van Knapp's hand selected portfolio. 2009 is the first full year of dividends and hence the start date for comparison.

2008 1670 998
2009 1991 1568 +21%
2010 1987 1799 +10%
2011 2247 1960 +13%
2012 2544 2179 +14%
2013 2802 2586 +8%

Of course it's not surprising that the higher yielding portfolio of the ETFs would jump out to a head start. But what's interesting is that the income differential would increase from 2010 through 2012. A steady or only slightly increasing high yield source such as VYM/HYG can fuel growth that rivals or exceeds a traditional dividend growth approach.

2013 is an estimate for both portfolios, but it appears that DVK will narrow the gap. Will that trend continue?

The main takeaway is that ETFs can certainly work for income generation and income growth when an investor gets even just a little creative with the combinations. That said, the above mix is pretty basic stuff for income investors; dividends from various sources and bonds, with a sprinkling of preferred shares.

This strategy may be very useful when an investor seeks immediate yield with some income growth. The strategy may be beneficial to those approaching retirement, or those entering retirement and transitioning growth stocks into retirement income.

That transition can be as easy as 1-2-3 ETFs. More on income strategies for retirees follow.

Know the risks.

Before you invest, do your research to fully understand the risk(s) of your holdings. And take a real honest look at your own risk tolerance level. It is also wise to investigate and consider the tax implications.

Disclosure: I am long VYM, SPY, DIA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Dale Roberts aka cranky is a Streetwise Coach at ING Direct Mutual Funds. The Streetwise Portfolios offer index-based complete portfolios to Canadians. Dale’s commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process.